Putting Microeconomics to Work

I’ve long been puzzled by the almost complete disconnect between real-world businesses and academic economics. After I graduated from college, I went to work as a management consultant. Almost nothing I learned as an economics major proved helpful to me in that job. Then, when I went back to get a Ph.D., I thought what I had learned in consulting would help me in economics. I was wrong about that as well!

Ever since, I’ve felt that both business and economics would benefit from a greater connection. Why don’t businesses set prices the way economics textbooks say they should? Why are randomized experiments so rare in business? Why do economists write down models of how businesses behave without spending time watching how decisions are actually made at businesses? The list goes on and on.

It’s taken a while, but the business/economics connections are finally starting to happen with greater regularity. John List and I wrote an academic piece about field experiments in businesses a few years back that focused on how partnering with businesses could help academics with their research.

The benefits are also going the other way. The Economist has a nice article about how microeconomists are adding value to businesses. (I’m sure the economists mentioned in the article are delighted to be included; I’m almost as sure they will hate the cartoon likenesses that accompany it!)

For what it’s worth, I’m trying to do my part to improve philanthropy and business through a little firm called The Greatest Good. But, damn, it turns out to be a lot harder to make things happen in the real world than it is in the ivory tower!

COMMENTS: 20

Pricing in particular, involves much more consumer psychology and partner relationships than basic economic models. Unfortunately, many businesses are very failure adverse (Silicon Valley is the most noted exception) and employees are made to fear taking risks which causes people to view trials as a sign of weakness. Many business leaders would accept a good-enough outcome and be seen as a successful, decisive leader rather than admitting what they don’t know and finding the best outcome.

I agree with the normative nature argument. In fact, one can argue that there is no such thing as objective theory as economic theory is based on assumptions which are themselves subjective. To illustrate this I wrote a piece about “the theory of relativity in economics” . Feel welcomed to take a look here:

Hmmm…I work as an industrial economist churning out forecasts in a commercial environment. Works just fine, as long as you pay only the attention to the holy doctrine of econometrics that it deserves (i.e. as little as necessary and as much as is needed) and more to your model specifications to reflect real-world behavior. It’s not that hard, but then again, it’s not that easy either. Then again, it’s not macroeconomics, nor is it microeconomics (strictly speaking), but in-between (150 sectors covering the supply side of the economy, and no, we’re not supply siders).

Key is understanding that academic work is symmetrical and tidy; the real world is asymmetrical and very messy indeed.

1) Skip the MBA.
2) Read “Up the Organization” by Robert Townsend.
3) For the small business: Read the original “The Lazy Man’s Way to Riches” Skip the DYNA/PSYC crap and go straight to the mail-order business part…which is mostly obsolete, but it applies to the Internet too. It describes the nuts and bolts of running a small profitable business. Don’t bother with all the rip-offs by other authors; only the original Joe Karbo edition will do.

There’s a simple reason for this. Most people in business are not trained in economics.

I work in the world of digital media ad sales. There is a bizarre belief among many in this industry that price is what drives overall income, rather than maximizing overall revenue with improved sell out levels. As a result, there is a striking differentiation in price between the inventory which is perceived as “best” – which is sold at a very high price, and that which is considered “worst” – and is sold as “remnant inventory” at very low prices (or not sold at all, in the case of certain very specialized publishers who seek to avoid the appearance of being low scale by running cheaper clients.

In my experience, having studied economics, I cared little about pushing price until I’d first maximized revenue by utilizing inventory effectively. At every company where I’ve had the opportunity to apply my approach, there have been immediate gains, which exceeded the average growth rate of the industry as a whole. Over time, as my policies continued to be applied, the gains continued to outstrip the industry rates.

I recognize there is a point at which this would stop being the case. If every site applied these rules, then each site would earn exactly (or somewhere close) to what the industry increase is, on average.

But one value of having my training is recognizing not everyone will apply these rules AND even if they do – not everyone will apply them effectively.

When I was trying to justify buying an inventory management system, a finance director asked “how much more money will it make us?” In his attempt to justify the expenditure, I explained it would not make us more money, per se, but give us the OPPORTUNITY to make more money. He failed to understand this simple fact. He took it another way.

“What if every site uses this inventory management tool? Then we lose that opportunity to make more money and everyone has the same opportunity.” No, I replied. You can give me a Stradivarius, but I do not how to make it sound good. Similarly, I told him, this tool will be useful in the hands of someone who knows how to manage inventory effectively – but will be lost on someone who does not.

This disconnect will always exist, and I am glad it does. It keeps the market healthy. I am always surprised how little people in business understand about economics, however. It’s amazing how people who can believe in evolution in the natural world seek to extend control over something they cannot. The concept of emergent order is so basic to an economist’s understanding of life and opportunity, it makes them generally more tolerant of change and gives them more opportunities over time to be successful.

I agree that the disconnect between actual businesses and business as studied by economists is due to the fact that many executives do not have a strong background in economics. Economic models as a rule simplify what would be rather complex market interactions, which may give the impression that they are useless in a real world situation. This simplification is important because holding certain factors constant enables one to isolate one important cause and effect relationship. Tailoring these models to a specific company or market would be extremely beneficial if done correctly. It is true that the use of past data generally means these models give good hindsight, but that does not mean that they are not good in predicting future trends, as all companies/markets are subject to historically repetitive patterns of consumption (i.e. the business cycle). Consider those business people that do have an economics background (Donald Trump, Warren Buffet, Sam Walton, and several presidents) who have all achieved an extraordinary level of success.